|Shares Out. (in M):||117||P/E||0||0|
|Market Cap (in $M):||1,550||P/FCF||0||0|
|Net Debt (in $M):||50||EBIT||0||0|
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When I first got into investing, I read an interview with Seth Klarman that kind of blew my mind. He said he focused on risk, not returns. And I shrugged at first and thought this was the usual "I believe in things that sound nice." Then I read the rest of the interview and realized that unlike most people, Klarman actually meant what he’d said. And it was shocking to me because, like most new investors, I was focused entirely on return. Return was the fun part. Risk, on the other hand, was amorphous and difficult and often defined as volatility, which even at a young tender age, I knew was a load of crap.
Now when I’m unsure what to do sometimes, I try what Klarman suggested. Take return out of the picture. Visualize it all in terms of risk. That’s a good intro to the idea I’m presenting because this idea doesn’t offer 50% near-term returns, but it does offer a modest return with very low long-term risk.
Fairfax India is a relatively new investment vehicle offered by Prem Watsa, the well-known and well-respected founder of Fairfax Financial. Watsa created Fairfax India because he sees tremendous value in India, a country with 7% economic growth and without much of a professional investor presence. Watsa has compounded capital 20% a year for decades at Fairfax Financial, and he is looking do the same with his new venture.
In a world where pretty much everything is richly-valued, India is one of the few places where you can find not just decent value but also market inefficiencies. While it’s unlikely Watsa can achieve the 20% returns he thinks he can, at least not over the short-term, Fairfax India offers the chance to earn 6-12% a year without exposing yourself to the potential permanent loss of capital facing investors in the US, Europe and Japan.
Two years ago, Tim321 posted a writeup on Fairfax India. While the stock has gotten more expensive, everything else seems to have gotten even more expensive. So while in an absolute sense, Fairfax has become less compelling, I think it is actually more compelling comparatively.
The Global Opportunity Set today
The US stock market has now reached one of the three most expensive points in the last hundred years. The situation isn’t much better globally. On the map below, red areas indicate markets where Robert Shiller’s CAPE ratio is high, and blue areas indicate markets where the CAPE ratio is low.
The CAPE ratio for the US market is now over 26, literally off the chart. Much of Europe has the same issue. Historically when the CAPE ratio has gotten this high, future 7-10-year returns on equities have been in the 0-5% range, which means US investors are facing the risk of another Lost Decade. The problem then becomes: if you want to invest outside the US, where do you go? When you look at the cheap places on the map, they’re a bit of a horror show. In Russia, there’s a 5% chance your shares will be cancelled due to changes in “the law.” In Brazil, you’re facing deep instability. Turkey is, well, it’s Turkey. There’s nothing there. China offers value, but has issues with leverage (though personally I like China).
One place that offers decent value is India, and India has significantly milder debt issues than those facing much of the rest of the world. What’s interesting about Fairfax India is that it offers access to India’s pretty opaque capital markets, and it offers it under the stewardship of a talented, ethical investor.
Sometimes referred to as Canada’s Warren Buffett, Prem Watsa has incredible track record. As mentioned, his firm Fairfax Financial has compounded capital at 20% a year since the mid-1980s. But Watsa not only has great returns. He has a great reputation.
Both are particularly valuable given how few credible investment managers there are in India. Like China, India in some ways is the wild west. Given how poor valuations have been worldwide, I have looked at investing in India for years. I’ve talked with several different investment managers, and frankly I would describe the feeling I get after those discussions as “alarm bells.” Many of the managers make wild, completely unfounded over-promises about future returns. They even do so in print. Prem Watsa is one of two, maybe three, people investing in India who I trust.
Before going on, there are two pretty substantial negatives to investing in Fairfax India. The first is fees. Watsa’s advisory firm charges Fairfax India a 1.5% management fee and a 20% carry subject to a 5% hurdle. This obviously will be a drag on returns.
The other big negative is that Fairfax India now trades at a 25% premium to book value. This in turn acts as a drag not on Watsa’s returns but on those for investors.
Combined, these two drawbacks mean that an investment in Fairfax India is unlikely to be a homerun. Those looking to double their money should look elsewhere. But those who’d like to outperform the market by 5-10% without increasing exposure to US equities or The Great Leveraging going on worldwide might find something worthwhile here.
Let’s start with the biggest positive: India itself. Economic growth has been projected to be 10% a year in India. That’s pretty rosy. The 7% India has been achieving lately is a far more sustainable figure. Also important to note is that while many economies since 2009 have eked out modest growth, they’ve done it on the back of explosive debt creation. India, on the other hand, has not. In fact over the last decade, India has deleveraged in terms of its government debt, reducing it from 85% of GDP to 70% of GDP. Still high, but acceptable, particularly since GDP growth is so high.
The same is true of India’s corporate debt, which is at high absolute levels but low compared to much of the rest of the world.
At the household level, though, India is under-levered. Household debt as percentage of GDP is 10%, compared to 80% in the US.
Another advantage of investing in India stems from how difficult it is for non-residents to do. India places heavy restrictions on trading by non-Indian residents. As a result, India’s capital markets remain largely outside of the global investment community, which helps create inefficiencies. Finally while the Shiller P/E of the US market is 26, India’s is only 17.6, which isn’t screaming undervaluation, but is decent value compared to everything else. And as you can see below, over the long run, valuation matters. The higher the Shiller P/E, the lower subsequent long-term returns tend to be.
Fairfax India has been capitalized with about a $1 billion of investor money. Since coming into being in 2015, Fairfax India has pretty rapidly put the capital it raised to use. Right now it has $575 million in equity investments, some money in bonds and then $430 million of undeployed capital, which Watsa says they are looking to deploy soon.
According Watsa, Fairfax India is looking to hold an extremely concentrated portfolio of companies, which is good because everyone will be focusing on their best ideas. Moreover they are looking to take controlling stakes where they can influence management, which increases the likelihood that portfolio companies will be managed well.
· Markel has put money into Fairfax India, which is a vote of confidence from a remarkable firm
· Fairfax Financial itself put $300 million into Fairfax India
You might be wondering why, if investments in India are so compelling, would Watsa take outside money. Why not keep it all for himself? I think it goes to value creation and value capture. As he’s revealed in interviews, he pretty clearly thinks that India is the most compelling place to invest in the world. He seems to think he can generate high returns, and he wants to capture a decent amount of that value creation. While the high fees are unfortunate, on the plus side they are a sign of Watsa’ confidence that they’ll be worth it.
In terms of what Watsa is investing in, he’s very bullish on the financial services sector. He also likes quality businesses with differentiated products/services.
Sizable investments so far are in:
· IIFL Holdings. A publicly-traded financial services company which makes home loans, personal loans, business loans and does wealth management and capital markets work. Fairfax India owns 27% of the business and has invested $277 million.
· National Collateral Management Services. A private agricultural commodities storage business. Fairfax India owns 88% of the business and has $149 million invested.
· Sanmar Chemicals. One of the largest suspension PVC manufacturers in India. Fairfax India owns 30% of the company and its bonds. Its total investment is $300 million.
· Bangalore International Airport. Fairfax India has committed $379 million and is set to own 38% of the company.
These aren't deep value investments. These are all potential compounding machines.
While Watsa seems to believe he can deliver returns on par with what he’s done before, I’m skeptical. 20% a year is pretty high. I think 15% a year is a more reasonable estimate. Assuming Watsa can achieve that, fees would drag a 15% return down to 11.8%. Then when we account for the fact that Fairfax India trades at 25% greater than book, that would reduce a Fairfax India investor’s returns to 9.4%.
I think that’s a fair estimate of what you could reasonably expect to earn on this over the long run.
Assuming Watsa can get 20% returns in India for the foreseeable future, investor returns would be 12.6%. And assuming Watsa can only get 10% returns, then investors would realize a 6% return.
These aren’t astronomical figures. However, they are very realistic figures. With Fairfax India, you have the opportunity to earn 6-13% a year in a world where returns are likely to be 0-5% a year. And you can do so in a country that isn’t in a stock market bubble and isn’t leveraged like it’s 1929.
If you define risk as volatility, then Fairfax India doesn’t offer lower risk. A major “risk off” event would likely involve a correction for pretty much everything. But if you define risk as permanent loss of capital, then Fairfax India offers significantly less risk than other situations around the world.
Fairfax India reduces two major risks: valuation risk and leverage risk. It does this by giving you entry into India, which then itself brings manager risk into the picture. But then Watsa himself mitigates this risk.
No matter how bumpy the ride is over the next, say, five years, I think Fairfax India will be worth substantially more than it is today.
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